Global share crash is a $5trn warning sign

LAST week three things happened that suggest the world – Scotland very much included – has entered a bumpy new economic phase. So fasten your seat belts.

First up: that global drop in share prices. Now shares go up and down, as everyone knows. But this was different. For starters, this mini crash came after a long and very unusual period of market stability – a bit like the point where animals go quiet before an earthquake. This made the tumble all that more frightening. In barely a week, share prices have lost a 10th of their value. Put another way, in the past fortnight the value of global companies has crashed by around $5 trillion – roughly twice the entire output of the UK.

We need to put this into perspective. This drop was not that huge, given that share values had ramped up from the start of the year. Call it the froth coming off the market. But everyone in finance knows it is a warning sign. This past decade we have lived through the biggest rise in share values in history. This rise has been driven artificially by two factors. First, central banks printing money (aka quantitative easing) deliberately aimed at boosting share purchases. And second, by low interest rates engineered via those same central banks. Cheap credit lets companies borrow to pay out high owner dividends, which in turn props up the shares irrespective of how well the company is really performing (think Carillion).

So why are markets getting jittery now? The main reason is the return of inflation. Last week’s sell-off was triggered on Wall Street after a report that US wages are rising steeply. Normal folk would consider this a blessing as it raises standards of living and boosts consumption. Investors, who are not normal folk, only see squeezed profits and rising prices. In turn, central banks will try to curb that inflation by ending quantitative easing and raising interest rates steeply for the first time in 10 years (as the Bank of England threatened on Thursday). Cue a rush to dump shares.

This sell-off was exacerbated by the fact that most share trading in the world is now done by robots. They buy and sell in nanoseconds based on average market trends. So if the market is rising, they buy. Which then makes the market rise again, and so on. This explains the lack of volatility in share prices that has seemed so spooky over the past year. However, if markets tip the other way and start to fall, then the robots start selling in nanoseconds. Result: last week’s instant crash. (Incidentally, if trading is done by robotic algorithms, why are you paying your pension fund so much in “expert” management fees? Answer: because you are being ripped off.)

Where are we now? Because shares are down a bit, there will be investors hunting bargains. For instance, despite the market drop, a lot of cash went into high-tech shares last week. So we could see shares see-sawing up and down for a bit yet. But in the longer run, sentiment has changed profoundly. Investors now expect a permanent “correction” – code for a serious collapse in share values. And that spells economic trouble.

Why? Because rising interest rates – the bottom line from all this – will expose lots of zombie companies, which will then go bust. As we noted above, companies have used low interest rates to borrow hand over fist. In the past six years, non-financial companies increased their debt holdings massively. Standard and Poor’s, the ratings agency, calculates that 37 per cent of companies are now “highly leveraged” – code for being unable to pay their loan debt if interest rates rise. Oops.

The second big economic event of last week happened on Thursday when the US Republicans voted to end austerity. Actually, the US right has talked more about austerity than practicing it, over the past decade. But now they have given up pretending to be in favour of fiscal disciple (though they attacked Obama for spending too much). The US Senate has just voted to boost discretionary spending by $300 billion over the next two years and cut taxes by $1.5trn. As a result, US government borrowing will soar, hitting $2.1trn a year. In relative terms, President Trump will be borrowing twice as much per annum (and rising) than miserly Chancellor Hammond.

Why is this important? Faced with growing economic volatility, competition from China and a return to a world of higher interest rates, the Trump administration has decided to abandon the norms of fiscal prudence beloved of Tory politicians in the UK. Instead, Trump will offset the impact of rising interest rates on US company debt by cutting business taxes to the bone. He will boost company sales by massive federal borrowing and spending, especially on arms and infrastructure projects. The Donald is a misogynist boor but he represents the interests of US capitalism and he does it well. Memo to all Tory Brexiteers: if you think President Trump will offer the UK a sweetheart trade deal, think again.

The third big event of last week was the announcement from the Bank of England that interest rates would rise ... but not just yet. Once again, Dr Carney at the bank talked a good game, then did absolutely nothing. This is curious as inflation in the UK is picking up far faster than in America or Europe. One explanation is that the bank is under pressure from shambolic British industry not to make life more difficult. The other reason is that any rise in interest rates will lead to a big jump in the amount the Treasury must pay out for its borrowing. That will squeeze cash for the NHS unless Chancellor Hammond borrows more. Cue a political crisis whatever happens. My bet is that friendless Mr Hammond has his coat at the Treasury hanging on a shoogly peg. Jacob Rees-Mogg for Chancellor, anyone?

What should Scotland do, given these increasingly choppy economic waters? The Scottish economy suffers from a massive dearth of private investment. That gap can only be filled by public investment or through the new Scottish Investment Bank. Finding the necessary capital may run up against Treasury rules. I’ve argued before that Scottish Government and MPs need to play hardball with the Treasury, including defying those rules. If we believe we have sovereignty, let’s use it. Playing the Westminster constitutional game means being defeated in the Commons voting lobbies every time. The next independence referendum should be about something the voters can understand – preferably the sovereign right of an elected Scottish Parliament to decide how Scottish taxes are raised and spent.

Will share prices fall further? Undoubtedly, for the market is still artificially high. When that great “correction” will come is anyone’s guess. Yet there’s a silver lining. The Scottish Government should move now to create a publicly owned, sovereign wealth fund. The bottom of the market will be the best time for this fund to buy shares – earning profits to fund the welfare state and giving Scotland more control over its own economic destiny. The lesson of the past week is that capitalism remains inherently unstable. Let’s do something about it.

Ipsoregulated

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